Global banks proposed alternative to Libor

Reuters reports that several global banks have approached the ECB with an alternative to Libor based on the interest rates they pay to raise money in the "secured market".

As justification for turning to the secured market, the banks cite the fact that the unsecured interbank lending market is frozen.

Regular readers know that there is a reason this market is frozen.  It is frozen because bank reporting leaves them resembling 'black boxes' and banks with deposits to lend cannot tell if the banks looking to borrow are solvent or not.

This has been true since the beginning of our current financial crisis (see:  conclusion of Financial Crisis Inquiry Commission).

Turning to the secured market does not address the issue of why the unsecured interbank lending market is frozen.  Rather turning to the secured market is an attempt to avoid taking the necessary step to unfreeze the unsecured interbank lending market.

The necessary step for unfreezing the unsecured interbank lending market is that the banks provide ultra transparency and disclose on an ongoing basis their current global asset, liability and off-balance sheet exposure details.  With this information, banks with deposits to lend can independently assess the risk of each borrowing bank and adjust the price on their loans based on this assessment.

Requiring banks to provide ultra transparency preserves Libor as a reflection of the banks' cost to raise money on an unsecured basis and allows market participants to exert discipline so that banks don't try to manipulate the rate.

A group representing some of the world's most powerful banks has approached the European Central Bank to seek backing for a new way to calculate the cost of funding after the Libor rigging scandal, people familiar with the matter said. 

The approach comes as a collapse in interbank lending and the threat of a regulatory clampdown have put in doubt the future of such benchmarks, driving a search for different ways to anchor the price of funding.

Actually, there is no need to search for a different way to anchor the price of funding when it is simple using ultra transparency to fix the problems with the current approach.

Members of the European Repo Council, a group attached to the International Capital Markets Association (ICMA), whose members include Deutsche Bank and Goldman Sachs, have discussed an alternative to Euribor (Euro Interbank Offered Rate) or its London equivalent with ECB officials. 

People who attended the meeting in Frankfurt last month said the group sounded out the central bank about setting up a benchmark based on actual "secured market" trades. Those transactions involve banks providing bonds, shares or other types of assets as security for loans. 

"We have Euribor and Libor and we know the problems with them," said one of the people. "The unsecured (interbank) market is also disappearing. So we need an alternative. A secured index makes a lot of sense."...

A secured index makes sense for a bank that wants to avoid providing ultra transparency and hide just how risky it is.

A secured index makes no sense for a bank that has nothing to hide.  A bank that has nothing to hide has a significant competitive advantage over its competitors who need to hide how risky they are.  The bank with nothing to hide can raise capital much less expensively.

The group also asked the ECB to oversee the calculation of the rate, to lend the new index credibility. But the bank's officials turned down such a role, saying their preference was for such benchmarks to be wholly market-run....

Excellent response by the ECB.

With ultra transparency, it is easy for benchmarks like Libor to be wholly market-run.

The new models to calculate funding, which could take many years to realise, would address another problem in a crisis that shows little sign of abating after half a decade: how to calculate an accurate price for funding when banks are unwilling or unable to lend to their peers.

As discussed above, the reason banks do not lend to each other on an unsecured basis is a lack of transparency.  Requiring the banks to provide ultra transparency will allow banks with deposits to lend to independently assess the risk of the borrowing banks and lend based on this assessment.  In addition, with ultra transparency, market participants will be able to calculate Libor based on actual transactions.

The group that runs Euribor - an arm of the European Banking Federation (EBF) - is examining a similar idea to that suggested by the banking group. 

"We plan to work short term on enhancing Euribor governance, process and supervision, and long term to continue working with all the ... stakeholders to see what could be done to adapt the fixing if the market was to change in the coming years," said Cedric Quemener, director at Euribor-EBF, which compiles the benchmark. 

"We ... are already working on a repo real-transaction-based benchmark," he said. "We have reached a consensus across European banks in supporting the repo effective project (named Reonia)." 

By reflecting the price of secured paper, such a model would give a more realistic picture of the price of funding and avoid relying solely on interbank lending....

The point of Libor and Euribor is to reflect interbank lending rates.  There is a reason to believe that banks with deposits to lend either have the internal expertise or will hire a third party to independently assess the risk of banks looking to borrow.  Therefore, Libor and Euribor really reflect the risk of lending to these banks on an unsecured basis.

Citigroup, one of the world's biggest banks and a major player in European money markets, left the Euribor rate-setting panel in September, citing "low interbank transaction volumes in the euro zone". ...

The low interbank transaction volumes are the result of the lack of disclosure by the borrowing banks.

It would also address the concerns of the European Central Bank, which has pushed for an overhaul of Euribor as well as a possible shift to actual market transactions, sources told Reuters earlier this year. 

The European Commission may also ask to shift the basis of the calculation to actual lending rates instead of the current system, which like Libor uses banks' assessments of what they expect to be charged. 

Britain's top financial watchdog, the Financial Services Authority, has also recommended that Libor be underpinned by actual market transactions where possible, with its governance stripped from an industry body. 

The U.S. Commodity Futures Trading Commission (CFTC) wants benchmarks based on real transactions as soon as possible....

With ultra transparency, Libor and Euribor would be based on actual market transactions.

"This is going to be taken out of the hands of industry," said one banker. "There is no way, given the importance of these indices, that they will be allowed to remain a best guess produced by industry for industry."

The way to permanently take this out of the hands of the industry is to require the banks to provide ultra transparency.  Then, all market participants can calculate Libor and Euribor.